The State of California’s Employment Development Department (EDD) is responsible for collecting employment payroll taxes to fund and administer unemployment and disability insurance, paid family leave, and other state programs. Beyond tax collection, the EDD also has the authority to issue audits to anyone operating a business within California. The main reason the EDD performs these audits is to detect and deter fraud regarding employment taxes.
If you or your business has received a notice of an EDD audit, here is what you can expect and how you can prepare. But first, let’s cover why you may have been audited in the first place.
What Triggered Your Audit?
An EDD audit is common if the EDD is concerned that your business has not correctly paid employment-related taxes or has mislabeled employees as independent contractors. An independent contractor who files for unemployment or disability benefits will raise suspicion with the EDD because contractors are not eligible for these programs.
Incorrectly Paying Wages and Filing Taxes
As the employer of record, it is your responsibility to withhold and then remit your employees’ income taxes and payroll taxes — including Social Security and Medicare taxes. Conversely, any independent contractors you have worked with are responsible for withholding and remitting their taxes.
As the employer, you are also responsible for filing employment tax forms and following federal guidelines on minimum wage and overtime payment. You are required to pay both employees and independent contractors within a reasonable period, and failure to do so may trigger an EDD audit.
Misclassifying Workers
Incorrectly classifying one or more of your employees as independent contractors might also cause an EDD audit.
Employees are subject to the control, jurisdiction, and oversight of the company, but contractors typically perform specialized work or projects under a contract. Contractors also set their own hours and negotiate their own pay, and they have little oversight, guidance, or disciplinary action from you or your business. If you blur these lines and treat your independent contractors like your employees, you might be viewed by the EDD as participating in an employer-employee relationship.
If you are unsure whether someone who works for you is an employee or an independent contractor, consider the questions provided by the California Department of Labor Standards Enforcement (DLSE). The DLSE Classification Test asks questions such as: does the work require a special skill; how much control do you have over how the work is performed; who provides the materials or equipment necessary, and/or are the costs related to these materials reimbursed; how permanent is the relationship; and others that can help you make a clear distinction. You may also file Form SS-8 with the IRS to help determine the classification of your worker.
The Process of an EDD Audit
Before the audit, you may want to collect all important records from the previous three years that can include (but are not limited to):
- check registers
- canceled checks
- bank statements and annual financial statements
- federal and state income tax returns and employment tax reports
- payroll records
- W-2 and 1099 Forms
- ownership verification
- and any other forms, records, or statements pertinent to your business.
During the audit, an auditor will first conduct an entrance interview, where the auditor will explain the purpose of the audit and outline its proceedings. You can ask the auditor general questions as they examine your employee classifications, wages, and the work that you contracted.
After the audit is complete, the auditor will discuss the results (known as a proposed notice of assessment, or PNA) with you, which you have a right to contest if you do not agree. You might have made overpayments, in which case you may receive either a refund or credit for next year. You might have made underpayments, in which case you may face a penalty determined by the IRS (pending certain exceptions). The EDD also has the authority to issue fines for certain transgressions, even if these actions were performed unintentionally.
The EDD will then share any information with the IRS, who may or may not choose to perform an additional audit.
In the event of an audit, it is suggested that you first get help from an experienced and knowledgeable tax attorney, who can help prepare your documents and guide you through the process. Contact our tax attorneys at Milikowsky Tax Law to get help navigating the EDD audit process and to make sure you are fairly represented.